23.1.3.1 The objective should be to ensure that the Contractor and its financiers are fully compensated7 (i.e. no worse off because of Authority Default than if the Contract had proceeded as expected).
23.1.3.2 The Contractor should be required to specify its preferred method of calculation of equity return at the time of its bid. It should choose between the level set out in the original base case, the market value at the time of termination and the original base case return from the Termination Date (see Section 23.1.3.6).
23.1.3.3 In most PF2 projects, equity is invested as a blend of share capital and Junior Debt. In calculating Authority Default compensation, many projects have distinguished between Junior Debt and equity.
23.1.3.4 Since in most PF2 projects, the substantial majority of "equity" is invested as Junior Debt, the approach taken in the early PFI/PF2 projects was to give the Contractor the opportunity of equity upside (through the market value compensation) but insulate it from downside (since Junior Debt is repaid in full). This is not appropriate. It is important that the same method of calculation (whether "market value" or "base case return") is used for both equity and Junior Debt. If the project concerned has an element of mezzanine debt then the Authority will have to consider the extent to which it is more akin to Senior Debt or Junior Debt8 and apply the termination compensation provisions accordingly. Guidance should be sought from departmental Private Finance units and/or HMT. Once mezzanine debt has been appropriately classified as Senior Debt or Junior Debt, it should be treated as such for all purposes under the Contract.
23.1.3.5 For similar reasons, calculations based on "the higher of base case return and market value" (giving the Contractor all upside but no downside) or "the lower of base case return and market value" (giving the Contractor all downside but no upside) are inappropriate.
23.1.3.6 Bidders must be invited to bid which of the following levels of equity/Junior Debt compensation they prefer:
• Compensation to reflect the base case IRR for equity and Junior Debt for the entire duration of the Contract. The purpose is to provide equity investors with the returns they expected from the Project at the outset, regardless of actual Project performance (whether better or worse than expected).
• The compensation payment is the amount which, when taken together with all amounts already paid to equity (in dividends/redemption payments etc) and Junior Debt (in interest and principal repayments) taking account of the actual timing of all such payments, provides equity and Junior Debt with their base case project-life IRR as agreed on signature of the Contract up to the Termination Date. Where equity or Junior Debt have already hit their project-life base case IRR, no payment should be made.
• Compensation to reflect the market value of both equity and Junior Debt for the entire duration of the Contract. The purpose is to allow the equity investors to take the full benefit of good Contractor performance but bear the risks associated with poor performance.
• The Authority pays an amount for both equity and Junior Debt based on their market value on a going concern basis immediately prior to the termination i.e. the amount for which the equity and Junior Debt could have been sold to a willing buyer at the relevant date (the calculation being based on the assumption that there had been no Authority Default and that both equity and Junior Debt were freely transferable).
• The market valuation will reflect the value of anticipated future cashflows (both revenue and costs); risk allocation under the Contract; and market appetite for Contracts of a similar nature. It will also take into account the value of the Assets (including any cash balances) held by the Contractor at the Termination Date.
• Compensation to reflect the base case return for equity and Junior Debt for the remainder of the duration of the Contract. This is an amalgamation of the first two approaches. The compensation payment is the amount of future return that the equity and Junior Debt providers originally provided for in the base case bid.
• Care should be taken that if a refinancing has occurred (see Section 28 (Refinancing)) and the original equity and/or Junior Debt reduced, there is no double counting.
23.1.3.7 The Contractor is likely to incur redundancy costs as a result of the termination of the Contract and, to the extent that these will occur, these should be included in the compensation payable by the Authority. Similarly, the Sub-Contractors may incur losses as a direct result of the early termination of the Contract (e.g. in respect of cancellation of orders for materials and goods). The Contract should specify those heads of loss which the Authority will pay to the Contractor, on account of the Sub-Contractors' losses. If the Authority proposes to offer compensation to cover the Sub-Contractors' future loss of profits, it should limit the period of time for which it will pay for such future loss (e.g. for a one year period from termination) and satisfy itself (through conducting due diligence over Sub-Contracts or otherwise) that the quantum of the loss of profit and other consequential losses and breakage costs are reasonable and appropriate.
23.1.3.8 The Authority should also decide what happens to the Assets following a compensation payment. As the Authority has fully compensated the Contractor, they should usually revert to the Authority. Where the assets may have a significant residual value and the Contractor retains the assets then different considerations will apply (see, for example, Section 24.6 (Retention of Assets by Contractor on Termination)).
23.1.3.9 In certain termination scenarios, the amount payable will be adjusted for any Additional Permitted Borrowing advanced by Senior Lenders (on a rescue refinancing) - see Section 24.3 (Certainty of Compensation Payment Amounts and Changes to Financing Agreements) and definitions in Schedule 1.
Required drafting is as follows:
23.1.3 Compensation on Termination for Authority Default
(a) On termination of the Contract under Clause 23.1.2 (Termination on Authority Default) the Authority shall pay9 the Contractor the "Authority Default Termination Sum" in accordance with Section 24 (Calculation and Payment of Early Termination Payments) on the Termination Date. Subject to paragraphs (c) to (e) below the Authority Default Termination Sum shall be an amount equal to the aggregate of:
(i) the Base Senior Debt Termination Amount,10
(ii) redundancy payments for employees of the Contractor that have been or will be reasonably incurred by the Contractor as a direct result of termination of this Contract and any Sub-Contractor Breakage Costs; and
either:
(iii) [an amount which when taken together with
(A) dividends (or other distributions) paid by the Contractor on its share capital on or before the Termination Date; and
(B) interest paid and principal repaid by the Contractor under the Subordinated Financing Agreements on or before the Termination Date,11 taking account of the actual timing of all such payments, gives a real internal rate of return on the share capital subscribed and amounts advanced under the Subordinated Financing Agreements equal to the Base Case Equity IRR.]
or
(iii) [the aggregate amount for which the share capital of the Contractor and the amounts outstanding under the Subordinated Financing Agreements could have been sold on an open market basis based on the Relevant Assumptions.12]
or
(iii)13 [all amounts shown in the Base Case as payable by the Contractor from the Termination Date, either in dividends or other distributions on the share capital of the Contractor or as payments of interest or repayments of principal made by the Contractor under the Subordinated Financing Agreements, each amount discounted back at the Base Case Equity IRR from the date on which it is shown to be payable in the Base Case to the Termination Date.]
(b) On payment of the amount referred to in paragraph (a) above, the Authority shall have the option to require the Contractor to transfer its right, title and interest in and to the Assets to the Authority or as directed by the Authority.
(c) If the aggregate of the amounts referred to in paragraphs (a)(i) and (a)(iii) is less than the Revised Senior Debt Termination Amount, then the Authority Default Termination Sum shall be increased so that it is equal to the aggregate of the Revised Senior Debt Termination Amount and the amount referred to in paragraph (a)(ii) provided always that:
(i) the amount referred to in paragraph (a)(ii) shall only be paid to the extent that the Contractor has demonstrated to the reasonable satisfaction of the Authority that the amount will not be paid in payment (in whole or in part) of any Distribution; and
(ii) if, at the time of termination, there are any Additional Permitted Borrowings outstanding, no Sub-Contractor Breakage Costs shall be paid in respect of any Sub-Contract in circumstances where there is an event of default under such Sub-Contract which would entitle the Contractor to terminate such Sub-Contract.
(d) If a Distribution is made whilst any Additional Permitted Borrowing is outstanding and the Contractor has wilfully, or through gross negligence, failed to comply with its obligations under Clause 11(d)(iv)(A) of the Direct Agreement then in addition to the deduction of the Distribution referred to in paragraph (v) of the definition of Revised Senior Debt Termination Amount, the Authority shall be entitled to set off the value of that Distribution a second time against the Authority Default Termination Sum, provided that the amount of the Authority Default Termination Sum will never be less than the Revised Senior Debt Termination Amount.
(e) If the Contractor has wilfully or through gross negligence failed to comply with its obligations under Clause 11(d)(iv)(B) of the Direct Agreement and there has been an overstatement of the cash balances by the Contractor as at that date which has caused the Authority to reasonably believe that it would be required to pay a lesser sum at the Termination Date than it actually is required to pay under the terms of this Clause 23.1.3, then the Authority Default Termination Sum, shall be reduced by the amount of such overstatement (to the extent such overstatement is still applicable at the Termination Date), provided that the amount of the Authority Default Termination Sum will never be less than the Revised Senior Debt Termination Amount.
means [•]%;14
"Losses"
means all damages, losses, liabilities, costs, expenses (including legal and other professional charges and expenses), and charges whether arising under statute, contract or at common law or in connection with judgments, proceedings, internal costs or demands;
means the assumptions that the sale of the Contractor is on the basis that there is no default by the Authority, that the sale is on a going concern basis, that no restrictions exist on the transfer of share capital, that no Additional Permitted Borrowing has taken place and therefore that the effect of the Additional Permitted Borrowing on the calculation of such amount is disregarded but that otherwise the actual state of affairs of the Contractor and the Project is taken into account;
"Sub-Contractor Breakage Costs"
means Losses that have been or will be reasonably and properly incurred by the Contractor as a direct result of the termination of this Contract, but only to the extent that:
(a) the Losses are incurred in connection with the Project and in respect of the provision of Services or the completion of Works, including:
(i) any materials or goods ordered or Sub-Contracts placed that cannot be cancelled without such Losses being incurred;
(ii) any expenditure incurred in anticipation of the provision of services or the completion of works in the future;
(iii) the cost of demobilisation including the cost of any relocation of equipment used in connection with the Project; and
(iv) redundancy payments; and
(b) the Losses are incurred under arrangements and/or agreements that are consistent with terms that have been entered into in the ordinary course of business and on reasonable commercial terms [and [ ]];15 and
(c) the Contractor and the relevant Sub-Contractor has each used its reasonable endeavours to mitigate the Losses;
23.1.3.10 This is the same level of compensation as is appropriate on a voluntary termination by the Authority (see Section 23.5.3 (Compensation for Voluntary Termination)). Choosing different approaches for these two types of termination could lead to the Authority to be incentivised to default in certain circumstances, which is why this document recommends that the methods used should be the same for both Voluntary Termination and Termination for Authority Default.
23.1.3.11 It should be noted that under certain scenarios shareholders in the Contractor may indirectly receive a proportion of compensation monies paid. Any public sector shareholder should be entitled to receive its proportion pari passu with other shareholders, under the terms of the Shareholders Agreement (see Schedule 4).
______________________________________________________________________________________________________________
7 The compensation payable should reflect a realistic calculation of an anticipated claim for damages and therefore should be an exclusive remedy of the Contractor leaving no residual claim for damages (see Section 24.7 (Exclusivity of Remedy)).
8 Mezzanine debt will typically seek a much higher return than Senior Debt. New sources of mezzanine pay become active in the PF2 market. These compensation provisions apply the same regardless of whether investors are private sector or public sector.
9 See Section 24 (Calculation and Payment of Early Termination Payments) for the rights of set-off against such payments.
10 See Schedule 1 (Definitions).
11 These amounts will take into account the initial investments of the shareholders.
12 The assumptions behind the sale include that there is no default by the Authority, that the sale is on a going concern basis and that no restrictions exist on transfer of share capital. The effect of any Additional Permitted Borrowing should be disregarded from the open market value calculation, but the actual state of the Project (e.g. any increased costs of operation or maintenance) should be taken into account in the open market value calculation. Required drafting for the relevant assumptions is set out in the definitions at Clause 23.1.3.
13 If a refinancing occurs then adding this figure to Senior Debt could give rise to an element of double counting. To the extent a refinancing is possible or likely this point will have to be addressed.
14 This is the real pre-tax (i.e. pre-tax with respect to Shareholders in the Contractor, post-tax with respect to the Contractor) blended rates of return for equity or amounts advanced under the Subordinated Financing Agreements (as appropriate) shown in the Base Case.
15 Authorities should consider inserting a relevant Sub-Contractor loss of profit cap as recommended by Section 23.1.3.7 or require bidders to bid relevant caps.